Paul Krugman: Snoopy the destroyer

Has Snoopy just doomed us to another severe financial crisis? Unfortunately, that’s a real possibility, thanks to a bad judicial ruling that threatens a key part of financial reform.

Some background: When catastrophe struck the troubled U.S. financial system in September 2008, the proximate cause was the looming collapse of three companies – none of which were banks in the normal sense of the word, that is, institutions that take deposits and lend them out. One of them was, of course, Lehman Bros.; the other two were The Reserve, a money-market fund, and American International Group, or AIG, an insurance company.

Lehman declared bankruptcy, while The Reserve, which had lost money with Lehman, froze customers’ accounts, and was eventually forced into liquidation. AIG was rescued by an $85 billion credit line from the Federal Reserve; in return, the Fed took 80 percent ownership of the company.

The episode showed that traditional financial regulation, which focuses on deposit-taking banks, is inadequate in the modern world. It’s not just that anyone who borrows short term to finance risky investments – which is what Lehman did – creates the same kind of danger as a conventional bank. There’s also a high degree of interconnectedness: AIG wasn’t a bank, but it was selling guarantees on financial assets, and fears that it might fail to honor those guarantees threatened to topple dominoes across the economy.

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Oh, and yes, the episode also showed that making the breakup of big banks the be-all and end-all of reform misses the point.

What we need is regulation that limits the risks from nonbank institutions – and the 2010 financial reform tries to do just that. The way it does this is by allowing regulators to designate some firms “systemically important,” meaning that, like AIG, their failure or the prospect thereof could threaten financial stability. Once an institution is so designated, it is subject to extra oversight and regulation.

What determines whether a firm is systemically important? There aren’t any cut-and-dried rules – there can’t be, because if there were, corporate lawyers would find ways to evade them. Instead, it’s a judgment call. But financial giants that don’t like being regulated are trying to use litigation to question those judgments.

Which brings us to Snoopy, who has, for reasons I don’t fully understand, long been the emblem of the insurance giant MetLife.

At the end of 2014 the regulators designated MetLife, whose business extends far beyond individual life insurance, a systemically important financial institution. Other firms faced with this designation have tried to get out by changing their business models. For example, General Electric, which had become more about finance than about manufacturing, has sold off much of its finance business. But MetLife went to court. And it has won a favorable ruling from Rosemary Collyer, a U.S. District Court judge.

It was a peculiar ruling. Collyer repeatedly complained that the regulators had failed to do a cost-benefit analysis, which the law doesn’t say they should do, and for good reason. Financial crises are, after all, rare but drastic events; it’s unreasonable to expect regulators to game out in advance just how likely the next crisis is, or how it might play out, before imposing prudential standards. To demand that officials quantify the unquantifiable would, in effect, establish a strong presumption against any kind of protective measures.

Of course, that’s what financial firms want. Conservatives like to pretend that the “systemically important” designation is actually a privilege, a guarantee that firms will be bailed out. Back in 2012 Mitt Romney described this part of reform as “a kiss that’s been given to New York banks” (they never miss an opportunity to sneer at this city, do they?), an “enormous boon for them.” Strange to say, however, firms are doing all they can to dodge this “boon” – and MetLife’s stock rose sharply when the ruling came down.

The federal government will appeal the MetLife ruling, but even if it wins the ruling may open the floodgates to a wave of challenges to financial reform. And that’s the sense in which Snoopy may be setting us up for future disaster.

It doesn’t have to happen. As with so much else, this year’s election is crucial. A Democrat in the White House would enforce the spirit as well as the letter of reform – and would also appoint judges sympathetic to that endeavor. A Republican, any Republican, would make every effort to undermine reform, even if he didn’t manage an explicit repeal.

Just to be clear, I’m not saying that the 2010 financial reform was enough. The next crisis might come even if it remains intact. But the odds of crisis will be a lot higher if it falls apart.